All About TIPS: Real Returns and Inflated Expectations

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Now that inflation is raging at highs not seen in the last 40 years, it’s no wonder that investments which guard against inflation have been experiencing a massive influx of money. With billions of dollars of new inflows every month, Treasury Inflation-Protected Securities (commonly referred to as TIPS) have quickly become some of the hottest portfolio options for nervous investors. And since questions about TIPS on message boards and in my inbox are apparently directly proportional to those cash flows, this feels like a good time to dig into the topic and separate the measurable truth from what passes as common knowledge.

How do TIPS work? How often have they succeeded in generating a real return above inflation? And are they really better than normal bonds without the inflation protection? Stick with me, and I wager you’ll learn a few things that may surprise you.

Table of Contents

Data Details


One of the more common questions I receive is why Portfolio Charts does not already include TIPS data in each tool. The simple answer is that they’re relatively new inventions without a lot of history to study. They were first introduced in the United States in 1997, and for reasons that we’ll talk about in a moment they’re pretty much impossible to accurately reconstruct from the available data before that date. So for a site that takes great pains to show long asset histories back to 1970 to avoid cherry-picking of start dates that exclude poor times to invest, TIPS just haven’t made the cut.

But that doesn’t mean that the data we do have isn’t useful or that I don’t have other tools with the ability to study it. For the purposes of this article, TIPS data is compiled from the always useful Simba Spreadsheet in combination with a few sources like ETFreplay. It accounts for modern expense ratios even in older index data. And I’m also going to crack open some of the downloadable standalone charts to illustrate TIPS performance over time.

The Appeal of TIPS


For those new to the asset, Treasury Inflation-Protected Securities are special types of treasury bonds that are specifically designed to account for inflation. When you buy a treasury bond, you give the government a loan and they agree to pay you a regular interest payment until your bond matures and they return the full initial principal. But while that’s the end of the story for traditional “nominal” bonds, inflation-protected bonds include one additional step.

For TIPS, rather than simply multiplying your original bond value by the fixed coupon rate, the government regularly adjusts your credited principal by inflation. So when inflation rises your bond value goes up, and when deflation arrives it goes down. Think of it as a life jacket for your investments to always keep the principal above water. Your interest payments vary along with that natural adjustment. And when your TIPS bond matures, you receive either the adjusted principal back or your original principal — whichever is greater.

Think about that for a moment while looking at the price of food and gas these days, and you can start to appreciate the appeal. The inflation protection right there in the name manifests itself in two ways. Not only will your interest payments rise along with inflation, but if you hold the bond all the way to maturity then you’re also guaranteed to not lose your initial principal to inflation or deflation.

On the surface, that sounds like a pretty good deal! Who doesn’t want an inflation guarantee, especially in today’s economic environment? So I can totally understand why more and more people are flooding into TIPS.

Historical TIPS Returns


While the inflation-protected story is certainly compelling, anyone who has read Portfolio Charts knows that I’m not one to simply follow the narrative without also running a quick sanity check with real data. So let’s set the sales pitch aside and run some numbers.

The largest TIPS ETF in the world is currently the appropriately-named TIP, with an eye-popping $28 billion in assets. It was launched in 2003 and tracks the entire US TIPS market from 1 to 30 years to maturity. If one backfills a handful of older years with data from its underlying Bloomberg index, then we can model the annual returns of the entire TIPS market back to 1998 (the first full year of TIPS data). Adjusting the numbers for inflation, we can then study things like the annual real returns and maximum drawdowns for TIPS to see if the measurable reality matched our expectations.

You know, like the idea that TIPS reliably protect your purchasing power.

Pop Quiz #1

Since the advent of TIPS in the United States, what percentage of the time has the TIPS market generated a negative real return below inflation?

Click for the answer
TIPS Annual Return

Wait — what? Losing money to inflation more than a third of the time probably isn’t what most people expect when they put their money in a product sold for its inflation protection. But at least it saves people when inflation is at its highest. Right?

TIPS Rolling Return

Note that the last deep red bar on the right is for the partial 2022 return through mid September. With inflation increasing at a near record rate, we’re currently on pace for by far the worst year for TIPS on record.

Ouch.

Now that I think about it, all of that unexpected red makes me wonder about drawdowns.

Pop Quiz #2

What is the longest compound drawdown that TIPS have experienced over the last 25 years?

Click for the answer
TIPS Drawdowns

The longest sustained drawdown to date was about 8 years, but the latest loss has erased previous recoveries and pushed it to 12 and counting. That’s a long time to wait for the promised positive real return to kick in, especially in a dataset of just 25 years.

But that’s ok, since surely TIPS have at least been safer than their nominal counterparts that are not adjusted for inflation at all.

Pop Quiz #3

Over the same timeframe since 1998, what percentage of the time has the total nominal treasury bond market generated a negative real return below inflation?

Click for the answer
Treasury Bond Annual Returns
For detail-oriented readers, note that for this chart I carefully selected the nominal companion index that has the same maturity profile as the previous TIPS data. The most applicable real-world index fund is GOVT. So the difference is all about the inflation protection.

Yes, you’re reading that right. Since 1998, nominal bonds have lost money to inflation less often than inflation-protected bonds. And what if I told you that if you compare them year by year, TIPS only bested nominal bonds in inflation-adjusted terms 64% of the time? Are you comfortable with it being closer to a coin flip than to a clear advantage?

TIPS vs. Nominal Bonds

Sure, we could get into the weeds on borderline years that could have flipped either way or fixate on the fact that TIPS did generate a slightly higher average real return overall. But for the purposes of this discussion, the larger point is simple:

TIPS in the real world are more complicated and less safe than many people realize.

Looking Deeper


With all of that data that runs quite counter to the current narrative around TIPS as the ultimate inflation protection asset, it’s possible that you may not know who to trust. But it’s really not about fact and fiction but about perspective. As with most investment discussions, it’s important to study the assumptions.

More often than not, when you see a TIPS proponent talking about their risk-free inflation protecting properties you’ll notice a caveat that I also included earlier which you probably read without a second thought.

“If you hold them to maturity without selling…”

Going back to the TIPS mechanics we discussed, if you hold a bond to maturity then you get the full original principal back. And in the case of TIPS, that principal is also adjusted for inflation. But — and this is a really important point — bond index funds don’t do that. In fact, they are often some of the most liquid products on the market with tons of transactions. They buy and sell bonds continuously as people join the fund or redeem shares, they constantly have to rebalance the bonds they hold to properly reflect the overall market per the prospectus, and they almost always sell bonds with one year left rather than hold them all the way to maturity.

With all of that trading activity comes a critical factor in TIPS that is the same for all bonds — capital appreciation. Bonds can be thought of as a contract. When interest rates fall, the value of your contract at the old higher rate rises. And when rates rise, the value of your contract at the old lower rate falls. So even when TIPS adjust the principal up for inflation, that increase in value can easily be dwarfed by the capital loss resulting from a rising rate environment. That’s how you see big TIPS losses today even with very high inflation.

For a thorough explanation, I discussed this behavior in detail in this article about bonds:

High Profits at Low Rates: The Benefits of Bond Convexity

Read the whole thing for everything you need to know about bond mechanics. Importantly, all of the same behaviors also apply to TIPS. Since the weighted average maturity of the TIPS market as a whole is about 7.5 years, TIPS are moderately sensitive to interest rate changes and can swing quite a bit. And when you’re starting a giant interest rate ramp-up from historic lows, the added convexity effect can make the losses pretty painful.

Long story short, TIPS are subsets of bonds. All bonds are sensitive to interest rate changes. And when rates rise, capital losses can outpace any inflation protection.

You know how the Federal Reserve actively fights inflation by hiking interest rates? Due to that intervention, TIPS have a nasty habit of getting kneecapped right when they’re needed most.

Like today.

Maximizing Safety


While TIPS funds following the whole market do lose a bit of their shine compared to their safe individual ideal, I think it’s only fair to also study the “hold them to maturity” option. Brainstorming ways to create the safest possible bond strategy, would following the suggestion to directly purchase low-risk TIPS fix the problem? Let’s find out!

Imagine for a moment you started investing in TIPS in December of 1997. At the end of every year, you dutifully purchased new 5-year bonds and held them all the way to maturity. Whenever they expired, you collected your initial inflation-adjusted principal and rolled it right back into new 5-year issues. The end result is what bond investors call a “ladder” that completely skips the secondary market and lets you manage your own income stream without any capital gains or losses from interest rate changes. And because the TIPS are short term, they’re also not particularly sensitive to interest rates anyway.

With constant interest payments backed by your inflation-adjusted principal guarantee, it’s hard to imagine a safer strategy.

I ran the numbers, and the results are indeed interesting.

Pop Quiz #4

Since 1998, how often did a personal ladder of 5-year TIPS lose money to inflation?

Click for the answer

Surprised?

Now to be fair, I should point out that the losses were all very small and never more than half a percent. That’s close enough to rounding error to arguably be negligible. So I think it’s reasonable to conclude that the ladder performed admirably in this scenario, and that you’ll be really hard-pressed to find a comparably safe way to preserve your purchasing power save for a few specific things like I-bonds or T-bills. As many people have pointed out, TIPS held to maturity really are an excellent option.

Still, I imagine you might be surprised to learn that even short term TIPS held to maturity can still lose money to inflation. How did that happen?

Everything Has a Tradeoff


As my old engineering professor liked to say, there’s no such thing as a free lunch. The inflation protection of TIPS is a valuable feature, and markets don’t like giving things like that away for free. The tradeoff for that inflation guarantee is that TIPS almost always offer a lower yield than nominal treasuries of the same maturity. The difference is equal to market expectations of future inflation over the life of the bond. And when rates are low and inflation expectations are high, the yields of TIPS can and do go negative.

For example, this chart shows the relative yields of 5-year nominal bonds (red) and 5-year TIPS (blue) over time. The green line at the bottom tracks the yield spread between the two options. Sometimes called the breakeven inflation rate, this represents market expectations of future inflation at each point in time. Note the negative yields on TIPS beginning in 2011.

This useful image is courtesy of Scott Grannis. Check out his website here.

Think about that for a moment. When you’re paying the government to hold your money for the next 5 years in return for the simple promise of eventually returning your inflation-adjusted principal, losing money shouldn’t be surprising.

This difference between the yields of nominal and inflation-adjusted bonds is why it’s not much better than a coin flip that one type of bond outperforms the other. The reason it’s called the breakeven rate is that it’s the precise future inflation required for holders of each type of bond to “break even” and receive the same return. But since future inflation is just a best guess, it may eventually end up higher or lower than that original market estimate.

In fact, because of how TIPS are priced based on market predictions of future inflation, one could argue that buying them is really just a speculative bet on inflation. If inflation turns out to be higher than expectations, inflation-protected bonds are the better deal. If it’s lower than expectations, nominal bonds are the better deal. And if the market lucks into a perfect prediction of inflation, then the two options are a wash.

And incidentally, the fact that the yields of inflation-protected bonds are dependent on market expectations of future inflation is also why they’re virtually impossible to academically model. I’ve seen a few very smart people try, but the results have never tracked reality to my satisfaction. Which should be no surprise, as any model predicated on the market sentiment of the future is destined to have huge error.

Did I mention that TIPS are complicated?

Takeaways


We’ve covered a lot of data, and if you’re like me seeing the charts for the first time I suspect your head might be spinning a bit. So as a quick recap, here are the most important things we’ve learned:

  • Even though they are adjusted for inflation, TIPS are not guaranteed to provide a total return above inflation each year. They gain and lose value based on prevailing interest rates just like all bonds. And capital depreciation in a rising rate environment can easily overwhelm any inflation adjustment.
  • Inflation-protected bonds pay a lower yield than nominal bonds of the same maturity. Since they’re operating with a handicap, they aren’t always the best deal. Sometimes they will perform better than nominal bonds and sometimes they won’t.
  • If you’re truly looking for safety from inflation, TIPS held to maturity are about as dependable as you’ll find. Short term index funds like VTIP are also pretty solid with only a small added amount of interest rate risk.

So are TIPS overrated? Or should you add some today? I know it’s probably trite to say this, but it’s complicated.

To be clear, I’m not a TIPS hater. I’m just a portfolio realist. Inflation is a real problem that justifiably worries a lot of investors today, and I understand that people are pouring money into TIPS for a good reason. The last thing I want, however, is to see hard-working everyday people blindly follow a solution that may fail to meet their needs when it matters the most. So to the extent that good data sets proper expectations and guides people towards appropriate solutions for their goals, I’m happy to to do my part spreading the word.

TIPS can absolutely be a fine addition to your portfolio, but it’s important to not put them on a pedestal. If you’re looking for inflation protection, they can be a highly dependable asset if used in very specific ways. But they can also set you up for major disappointment if you don’t fully understand all of the other nuances that play into their performance. So be smart about it, and always take the time to understand your investments. Knowledge is power. And hopefully you learned something new.

Are you interested in using TIPS to protect your portfolio against inflation? Approach them not only with an open mind to possibilities but also with open eyes to reality, and you’ll be well-positioned to make a smart choice.


If you found this analysis interesting and would like to duplicate it with other assets, check out the spreadsheet downloads. Paired with a free Office account, you can create charts in no time. And if you feel smarter for reading this, donations are always appreciated!